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A Review of Paul Krugman, The Return of Depression Economics

J. Bradford DeLong
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

May 1999

Paul Krugman (1999), The Return of Depression Economics (New York: W.W. Norton: 039304839X).


This is a book that anyone interested in international economic policy and the possible destinies of the world economy needs to read. Paul Krugman is, as I have said before, the best claimant to the mantle of John Maynard Keynes: an extremely knowledgeable professional economist, an excellent writer, and an incisive critic of what international economic policymakers are doing wrong.

But no one should read The Return of Depression Economics thinking that they will learn answers. Krugman does not have any answers. In large part this is because this book was written too quickly--but it had to be written quickly if Krugman is to have influence over debates and policies, rather than just join the rest of us who aspire to clean up after the elephants once the parade has gone through. In part this is because Krugman guesses wrong in a few places: writing in January he forecast that by now the Brazilian economy would be in either hyperdeflation or deep recession.

So while the book is great at laying out the basic issues in the management of the global economy, it is already out-of-date as far as the choices facing us are concerned, and--as I said above--I think that it was written too quickly to be able to provide us with the answers that we need. There are parts of the book I love. There are parts of the book I question. And then there are parts of the book I hate.


Japanese stagnation

The core of Krugman's book is made up of analyses of the two greatest economic disasters of the 1990s: the lost decade of economic growth in Japan, and the waves of currency crises and depression that have rolled around the world from Britain and Sweden in 1992 to Mexico and Argentina in 1995 to East Asia's rim in 1997 to Brazil in 1998-1999. These are the parts of the book I love.

Krugman's analysis of how the Japanese economy entered its present period of stagnation is lucid, clear, and accurate. The collapse of the financial bubble of the 1980s depressed consumption and investment spending. Banks' and other institutions' large bets on the real estate market meant that the collapse of the bubble put them "underwater"--with assets and lines of business that were worth less than the debt they already owed that they had borrowed to speculate in real estate. Who will invest in a business--or a bank--if you fear that your money will be used not to boost profitability but instead to pay back creditors who had loaned to the business before you?

The answer to what you should do in order to recover from such a state of depressed aggregate demand is "everything." You should have the government run a substantial deficit (although, as E. Cary Brown of MIT pointed out in the 1950s, it requires truly awesome deficit spending--on the order of deficit spending in World War II--to reverse a Great Depression like the U.S. in the 1930s or a Great Stagnation like Japan today). You should have the central bank push the interest rate it charges close to zero (to make it very easy and cheap to borrow money). And if that isn't enough you should--as Krugman advocates--try to deliberately engineer moderate inflation. If demand is depressed because people think investing in corporations is too risky, change their minds by making the alternative to investment spending--hoarding your money in cash--risky too by having a share of its real puchasing power eaten away every year by inflation.

So far Japan has changed its fiscal policy to run big deficits (but, as any student of the Great Depression would suspect, they haven't been big enough). Japan has lowered its short-term safe nominal interest rates to within kissing distance of zero. But these haven't done enough good. And so Krugman thinks it is time for the deliberate engineering of inflation to extract Japan from what economists call its "liquidity trap."

But at this point Krugman doesn't have all the answers. For while the fact of regular, moderate inflation would certainly boost aggregate demand for products made in Japan, the expectation of inflation would cause an adverse shift in aggregate supply: firms and workers would demand higher prices and wages in anticipation of the inflation they expected would occur, and this increase in costs would diminish how much real production and employment would be generated by any particular level of aggregate demand.

Would the benefits on the demand side from the fact of regular moderate inflation outweigh the costs on the supply side of a general expectation that Japan is about to resort to deliberate inflationary finance? Probably. I'm with Krugman on this one. But it is just a guess--it is not my field of expertise--I would want to spend a year examining the macroeconomic structure of the Japanese economy in detail before I would be willing to claim even that my guess was an informed guess.

And there is another problem. Suppose that investors do not see the fact of inflation--suppose that Japan does not adopt inflationary finance--but that a drumbeat of advocates claiming that inflation is necessary causes firms and workers to mark up prices and wages. Then we have the supply-side costs but not the demand-side benefits, and so we are worse off than before. Something like this happened to the Popular Front government of Leon Blum in France in the late 1930s.

Thus senior officials of the U.S. government have a problem. Since at least the replacement of the Bush by the Clinton administration, the accepted doctrine inside the U.S. government is that Japanese economic policy ought--for Japan's own sake, and for the rest of our's--to be "more Keynesian." Quiet whispers of advice to Japanese policymakers may, but probably will not, have much influence on what policy actually is. Loud shouts through public megaphones do have a greater chance of influencing actual policy, but also run the risk of triggering adverse shifts in aggregate supply.

Part of the arcana imperii--the secret knowledge of government--of economics is that "Keynesian" policies (like those advocated by Krugman) are most successful when they are enthusiastically adopted by were not generally anticipated, much less effective when they are both adopted but also anticipated, and positively destructive when they are anticipated but not actually adopted and implemented. In my view, at least, these considerations make it a much harder problem than Krugman suggests to discern the best course of action for Japanese economic policymakers, and for government officials outside of Japan who wish the Japanese people well.


Currency crises

But the center of the core of Krugman's book is his analysis of the wave of financial currency crises that have hit the world in the 1990s. The collapse of the European Monetary System in 1992, the collapse of the Mexican peso (that then spread to other Latin American currencies) in 1994-5, and the East Asian financial crisis of 1997-8, the Brazilian crises of 1998-9. One international financial crisis every two years is a lot.

In all these cases the root of the crisis is a sudden change of heart on the part of investors in the world economy's industrial core--in New York, Frankfurt, London, and Tokyo. In Mexico in 1993 international investors poured some $25 billion into the economy; in Mexico in 1995--even theough the peso had been devalued by two-thirds, every piece of property and every business in Mexico was thus three times cheaper, and the country was the same country--international investors took perhaps $10 billion out of the country. In East Asia in 1996 international investors poured perhaps $70 billion into the region's economies. In 1998 the net private capital flow was about -$40 billion.

The root causes of all of these crises lie in sudden changes in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way and investing in the particular "emerging market" at the center of the crisis in 1993 or 1996, and then they turned around and were all going the opposite way and pulling their capital out of the "emerging market" even if they had to sell it at fire-sale prices two years later.

Economists will long dispute which was less rational: Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business, or was the stampede of captal out of emerging markets an irrational panic? The correct answer is probably "yes"--the market was manic, and was panicked, and the sudden change in opinion reflected not a cool judgment of changing fundamentals but instead a sudden psychological victory of fear over greed.

So if sudden changes of opinion by international investors cause so much trouble, shouldn't we keep such sudden changes of opinion from having destructive effects? Shouldn't we use capital controls and other devices to keep international flows of investment small, manageable, and firmly corralled? Shouldn't we--as Mahathir Muhammed has done and as Paul Krugman advocates--impose capital controls?

The first generation of post-World War II economists would have said "yes." The second and third generations regretted that capital controls kept people with money to lend in the industrial core away from people who could make good use of the money to expand economic growth. The balance of opinion shifted to the view that too much was sacrificed in economic growth at the periphery for whatever reduction in instability capital controls produced--especially since the regime of capital controls was one in which the cousin of the wife of the vice-minister of finance somehow received permission to import capital, and thus capital controls paved the way to kleptocracy: rule by the thieves.

So today we have the benefits of free international flows of capital. The ability to borrow from abroad gives successful emerging market economies the power to cut a decade or two off of the time it takes for them to industrialize. But this free flow of financial capital is also giving us one major international financial crisis every two years.

So what is to be done when such a crisis hits--if we are going to try to do better than to abandon the ability of the third world to draw on the first world's financial reserves to finance industrialization?

Perhaps the best way for policymakers in an emerging market to think of a sudden panic by investors in the industrial core is that it is a sudden fall in demand for your country's products. Before the panic, you had lots of exports on what economists call the capital account of the balance of payments: you sold to investors in the industrial core factories in your country, businesses located in your country, and bonds issued by your businesses and your governments. But now, after the panic, this demand has dried up.

What does a business firm do when all of a sudden demand for the products it makes falls? The firm cuts its price. A country faced with a sudden fall in demand for the products it makes should do the same: it should cut its price. The easiest way for a country to cut its price is by allowing its exchange rate to depreciate--to let the price of the peso fall from 4 to the dollar to 8 to the dollar is roughly the same as a business firm responding to a fall in demand by offering 50% off.

But there are situations in which the natural thing, the obvious thing, the "Keynesian compact" thing (as Paul Krugman calls it) runs into problems. Suppose that your banks, businesses, and governments have borrowed massively abroad and have done so not by promising to pay back their creditors in pesos but by promising to pay back their creditors in dollars (or yen, or euros, or pounds). Then a depreciation of the exchange rate bankrupts the economy: the dollar value of all the banks' and businesses' assets are halved by the depreciation while the dollar value of their liabilities is unchanged. Such an interlinked chain of general bankruptcies destroys the economy's ability to transform household savings into investment expenditures, and is the stuff of which Great Depressions are made.

Just as bad, in many emerging economies belief that inflation will remain low is closely tied to the stability of the exchange rate. A large depreciation of the exchange rate runs the risk of setting off a large adverse shift in aggregate supply as expectations of inflation become general--and of causing the economic chaos that follows from way-out-of-control inflation.

But not depreciating the exchange rate is no solution either. In order to keep massive capital flight--both because of core investors' panic, and because those who haven't panicked expect depreciation because it is the natural thing to do--from occurring, interest rates would have to be driven to sky-high levels. And such sky-high interest rates choke off investment, trigger chains of bankruptcies, and lead to Great Depression as well.

So is there a possible path to safety? Can you raise interest rates enough to keep the depreciation from triggering bankruptcy and hyperinflation, while still avoiding a high interest rate-generated recession? Can you depreciate the exchange rate far enough to restore demand for home-produced goods without depreciating it so far as to bankrupt local businesses and banks? Maybe.

The dilemmas are real. The IMF, the U.S. Treasury, and national governments affected try to solve them. Paul Krugman does a very good job of laying out just why it is that the "Keynesian compact" can no longer be kept. I agree with Krugman that economic policy malpractice is being performed by those who (like Jeffrey Sachs) claim that it is obvious that in a financial crisis interest rates should not be raised and the exchange rate allowed to find its own panicked-market level and those who (like Robert Bartley) claim that in a financial crisis interest rates should be raised high enough to keep the exchange rate from falling at all. It's not that simple.


Understanding the IMF view

But--and here we come to the parts of the book that I question, and that I think were written too quickly--I am not sure that it is right to categorize the IMF and U.S. Treasury view as that "...sound economic policy is not sufficient to gain market confidence," that the economic textbooks need to go "right out the window as soon as the crisis hit[s]," and to conclude that this IMF and U.S. Treasury view "sounds pretty crazy, and it is" (pp. 113-4). And I think it is definitely wrong to conclude that there were "no good choices... no way out... nobody's fault that things turned out so badly" (pp. 117).

The reasons that the IMF and U.S. Treasury view is not "pretty crazy" are twofold. First, as noted above, the path that avoids either the disaster of high interest rates or the disaster of general bankruptcy is narrow (if it is there at all): countries that have large amounts of hard currency-denominated debt or have inflation expectations keyed to the exchange rate cannot implement the textbook policies of the Keynesian compact without disaster. Second, the IMF's primary goal is not to provide money so countries can adopt the policies that make them better off. The IMF loans countries money in order to give them more options for policy, yes. But the IMF's first imperative is to make sure that it gets its money back--for if the IMF doesn't get its money back, then the IMF will be unable to lend to the countries affected by the next financial crisis, for the IMF will have vanished as an institution.

You may wish that the IMF had different goals. If it were a true world central bank, it wouldn't have to worry much about getting paid back. It could tune its policies to do the most good worldwide. But it isn't a world central bank (although I wish that it were). And I think that Krugman misreads the IMF's motives and objectives and fails to recognize that much IMF "conditionality" is imposed not because it is good for the borrowing country as because it is good for the institutional survival of the IMF (and thus, presumably, for the other countries that will borrow from the IMF in the future).

Thus I think Paul Krugman misses the first and biggest thing that could be done to make the world economy better. Refund the IMF. Boost its resources tenfold, so that it no longer has to worry so much about having one single large borrower fail to repay. Then the IMF could act more like a world central bank, and adopt policies aimed at minimizing unemployment and recession rather than policies aimed at maximizing the short-term export surpluses of borrowers.

But Krugman certainly gets the second and third positive things that can be done right. Strongly discourage--tax--borrowers in the periphery from borrowing in the hard currencies of the industrial core. If you are going to accept free international capital flows (in an attempt to use foreign financing for your industrial revolution) then be sure that your exchange rate can float without causing trouble for the domestic economy. If your exchange rate must stay fixed (for inflation-fighting or other reasons), then recognize that an important part of keeping it fixed are controls over capital movements.

We don't have to have a global economy as vulnerable to currency crises as the economy of the 1990s has been.


Being pedantic

And then there are the aspects of the book that I absolutely hate. I am a pedant. And the book lacks references and footnotes.

The book jacket flap refers to the "Federal Reserve Board's bailout here in the United States of the over-leveraged Long-Term Capital Management Corporation." You--reading this--think that it probably means that the Federal Reserve loaned LTCM a very large sum at low interest rates, or foregave a substantial debt that the LTCM owed it. Not so: what happened is that the Federal Reserve Bank of New York gathered LTCM's major creditors and LTCM's principals together in a room, and said to them "you have a big problem; fix it." Now surely the Federal Reserve brought something to the table besides supplying the coffee for the meeting: those creditors who were thinking about demanding all their money up front now surely thought that the Federal Reserve was taking names, and that being uncooperative was to expose oneself to certain risks should one ever need something from the Federal Reserve (and, conversely, that being cooperative meant that one's case in the future would be listened to more sympathetically than otherwise).

Now this is not laissez-faire. This is the government putting its thumb on the scales of the market. But to call it a "Federal Reserve...bailout" is to miss flatten the landscape, and suppress important distinctions and nuances about how government intervention in financial markets actually works in practice.

Or consider page 56, about the Mexican peso support package of 1995, where Krugman writes that "... the U.S. congress would not approve any funding for a Mexican rescue... it turned out that the U.S. Treasury can at its own discretion make use of the Exchange Stabilization Fund.... The intent of the legislation that established that fund was clearly to stabilize the value of the dollar; but... with admirable creativity Treaury used it to stabilize the peso instead." This story leaves out the letter from the Speaker of the House (Gingrich) the Minority Leader of the House (Gephardt), the Majority Leader of the Senate (Dole), and the Minority Leader of the Senate (Daschle) all urging--begging--the Treasury to perform this creative use of the ESF so that they could go back to the members of congress--of both parties--and receive their applause for having enabled the members to duck a difficult vote.

Thus it is not quite correct to say that the U.S. congress would not approve any funding. The U.S. congress was eager for the Treasury to assume responsibility but also would rather have seen the Treasury act than not. Once again important distinctions and nuances--in this case that much of the time the overriding goal of congress is to hide, and make sure that making substantive decisions is somebody else's responsibility. A nuance, you say? Yes, but in my view an important one.

All authors face this problem: to tell the whole story about anything is impossible, and to tell less than the whole story is inevitably to distort--somehow. In my view Krugman has done as good a job as anyone could: I can't improve on him without taking more space for explanations.

But this is what footnotes are for: footnotes are supposed to signal readers where stories have been (necessarily) simplified in order to fit on the page, and direct curious readers to places where they can find the stories told at greater length, with more attention to details and nuances.

But this book has no footnotes, no references. When Krugman writes of the "... strand of thought that says that moderate inflation may be necessary if monetary policy is to be able to fight inflation... one notable exponent of this view, in his pre-government days, was Deputy Treasury Secretary Lawrence Summers," I know that Krugman is referring to J. Bradford DeLong and Lawrence H. Summers (1993), "Macroeconomic Policy and Long-Run Growth," in Policies for Long-Run Economic Growth (Kansas City: Federal Reserve Bank of Kansas City: ), pp. 93-128. But I (and Larry) may well be the only people who will know what Paul means. And we know it only because we wrote it, for we are the authors of the piece to which Paul's footnote, if it existed, would point.

Now I understand that editors at Norton fear footnotes, and think that they greatly reduce the audience for the book. But at least put them up on the web!


Conclusion

Paul Krugman is always worth reading. He is usually right, and when he is wrong he makes you think hard about why.

This book is one in which he is wronger than he usually is: 75% right on my estimation, as opposed to his usual score of 90% right. (That is, 90% agreement with Brad DeLong.) The main reason for his lower score is that he wrote this book in medias res in the hope of having an impact--thus he forecasts economic disaster for Brazil by mid-1999, and we can look around and see that (at least as of this moment), Brazil appears to be weathering its crisis. But a second reason for his lower score is that he does not seem to have fully absorbed the lessons of the 1970s: that the Keynesian compact does not always work, and that worrying about aggregate demand alone leaves you vulnerable to disturbances to aggregate supply. And a third reason is the speed with which the book was written: I wonder whether on reflection Krugman might blame defects of IMF policy more on its institutional situation and less on muddled thinking by Michel Camdessus and Stanley Fischer.

But, fourth, the issues are very hard ones. I know that my own views are evolving fairly rapidly. I doubt that if I had written a book on this last year that I could attain 75% correctness--understood as 75% agreement with my self today.

Add a comment: Feedback
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You are more right than Prof. Krugman on the IMF view in regards the lastest round of currency crises, that is I agree with you more than I agree with Prof. Krugman. Of course, "the IMF's first imperative is to make sure that it gets its money back." My opinion to that effect was published in a local newspaper two years ago. But, I disagree with your proposed new role for the IMF: "Refund the IMF. Boost its resources tenfold, so that it no longer has to worry so much about having one single large borrower fail to repay. Then the IMF could act more like a world central bank, and adopt policies aimed at minimizing unemployment and recession rather than policies aimed at maxmizing the short-term export surpluses of borrowers."

The problem with the crisis was not the lack of a global money printer but moral hazards, e.g carry trade and the like. The local (Thai, that is) bankers have already been proven wrong for having thought that there are such things as low risk high return investments.

When capital was stampeding into Thailand, it came mostly in form of cross-border interbank loans. When capital was stampeding out of Thailand, it went again mostly in form of cross-border interbank loans (or more precisely the repayment of the loans).

The local banks have paid dearly for their past imprudent practices. Hopefully the punishment will teach them against any future over-reliance of cheap short-term foreign capital. Unfortunately, the international banks who were lending imprudently the local banks have hardly suffered. Any suffering they may be enduring now is indirect. Some international banks are getting caught with problem on their long-term loans to non-bank companies which, as a consequence of the currency crisis, have been unable to continue servicing their debt.

The problem is those banks who got their hot capital back are not always the the same banks who got their cool capital stuck. So, the imprudent short-term cross-border interbank lending will continue.

I am not going to pretend that I know 'the' solution. Whatever the solution to the current global vulnerability toward currency crises must, however, keep the moral hazard of cross-border lending in check. A theoretical, but not so practical, solution is to do away with the IMF altogether. Hopefully, a gentler and kindler solution will come around. Libertarian doctrinairians, though, probably say "Bah! Humbug!".

Contributed by Visoot Phongsathorn (visoot_p@banpu.co.th) on January 10, 2000.


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